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Vanguard settlement over 2021 target funds distributions
The reporting on this has left me rather confused. As near as I can tell, Massachusetts was focused on the marketing of the funds, not how Vanguard disrupted them. The WSJ writes:
Vanguard hadn’t explicitly warned investors that the funds could generate gigantic tax bills, the Journal reported. ... In January, following the Journal’s report, Massachusetts regulators launched an investigation into how Vanguard had marketed the funds.
And an earlier Wealth Management.com piece talks about Mass.' concerns with "'potential tax disclosure issues' with b/d's target date funds" and that Mass. sent letters to "Vanguard, Fidelity Brokerage Services [not FMR as manager of its target date funds], ...".
All of which leads me to think that this settlement has got nothing to do with how Vanguard generated the cap gains distribution and everything to do with how the funds were sold.
Assuming that's correct, wouldn't any broker/dealer who sold these funds be a target of Mass.' ire? Admittedly most sales of Vanguard fund shares to retail investors are direct through Vanguard.
• Capital gains distributions may vary considerably from year to year as a result of the Funds' normal investment activities and cash flows.
If the target date funds failed to give adequate disclosure about potential risks (viz. that a large exodus could generate ginormous tax bills), then likewise VHCOX has failed to give adequate warning. The only difference is that the VHCOX investors haven't gotten burned yet.
An additional source of confusion is that none of the reporting indicates what effect, if any, this will have on investors' suit against Vanguard - for creating the tax liability, not for failing to warn. Does the settlement preempt this suit? Does the settlement permit investors to opt out so that they can continue their suit. What is the status of the investor suit?
@msf : Are the investors ahead of the "game" due to the fact that Mr. Market took a dump after the first of the year. After paying the tax , Mr Investor could now buy back more of the funds that got hit with high CG's at a lower price. Thus now one would have more shares & hope to make a $ when the market recovers. Thanks for your time, Derf
I suppose it's possible, but the investors would had to have been lucky in their timing. For example, suppose they looked at Vanguard's projected cap gains distributions and decided that they had to pay a Q4 estimate by Jan 15th. They might have sold at the top of the market.
OTOH, if investors waited until early April to sell shares to pay the extra taxes, they already lost quite a bit.
Either way, one has to ask where they're getting the cash from to buy back their shares. If they had the cash on hand, they might not have sold their shares to pay the extra taxes.
Another concern is that the large distributions put many investors into higher tax brackets, even for cap gains. They might have been in the 0% bracket but got pushed into the 15% bracket. And those in the 15% bracket might have been pushed into the 20% bracket. Not to mention the 3.8% Medicare surtax on investment income above a certain threshold.
Given that target date funds are designed to be an all-in-one portfolio, it would not be surprising to see even relatively small investors pushed into higher brackets.
In short, it's a nice hope that some of these investors came out better by being forced to sell shares at a market high. But given the difficulty in raising cash to rebuy later, given the higher brackets that their "windfall" pushed them into, it seems more likely that they got creamed.
Was it possible for Vanguard to preemptively convert retail fund shares (for $100M+ accounts) to institutional fund shares and avoid this debacle?
Yes and no. For, say the 2030 target date, there were two completely different funds. A retail fund and an institutional fund. What Vanguard did was lower the amount required to get into the institutional fund - thus triggering a mass migration.
The retail fund didn't have institutional shares (at least I don't think so). So Vanguard could not simply convert shares in the retail class. But Vanguard could have created a new $100M min share class in the retail fund and then converted shares. Then institutional investors wouldn't have migrated from the retail fund to the institutional clone.
Thanks, msf. I wonder why Vanguard didn't create a new $100M minimum share class and then convert shares. This would have saved some retail investors a lot of grief!
There was a Regular TDF series (with multiple classes, including its own Institutional class), and another distinct Institutional TDF series ("Institutional" was in its name) with super high minimum and super low ER. Then 2 VG events happened, in hindsight, in a very poor way/order. First, the minimum for the Institutional TDF series was lowered that caused the stampede out of the Regular TDF series into the Institutional TDF. Second, the Institutional TDF series was merged into the Regular TDF series (so, the Regular TDF name and tickers were the survivors) and the new ER lowered below the ERs of both series forms. So, all that money that flowed out of the Regular TDF from step #1 came right back into the Regular TDF after merger step #2. In its PR releases at the times, VG mentioned only the ER savings in step #1 and then also in step #2, and didn't mention/acknowledge/admit the CG tax issues/hits by nonretirement investors until the class action suits and state regulatory actions were filed. This is called penny-wise, pound-foolish.
What VG should have done? Instead of step #1, it should have just lowered the ER of the Regular TDF institutional class to match that of Institutional TDF ahead of the merger, and then the merger step #2 wouldn't have created all this mess.
That's why Vanguard would had to have created a Regular TDF institutional class.
Edit: As I think about it, creating such a share class would have been problematic. Vanguard charged no management fees or any direct fees at all for these funds. The total ER came from acquired fund expenses. That's likely why Vanguard created a clone fund with lower expenses. The institutional clone cost less because it purchased less expensive shares of the same underlying funds. I don't know how Vanguard could create a share class of the retail series with lower charges than what the underlying funds were charging.
DESCRIPTION OF THE TRUST Vanguard Chester Funds (the "Trust") currently offers the following funds and share classes (identified by ticker symbol):
Share Classes Fund Investor Admiral Institutional Vanguard PRIMECAP Fund VPMCX VPMAX Vanguard Target Retirement 2015 Fund VTXVX — — Vanguard Target Retirement 2020 Fund VTWNX — — Vanguard Target Retirement 2025 Fund VTTVX — — Vanguard Target Retirement 2030 Fund VTHRX — — Vanguard Target Retirement 2035 Fund VTTHX — — Vanguard Target Retirement 2040 Fund VFORX — — Vanguard Target Retirement 2045 Fund VTIVX — — Vanguard Target Retirement 2050 Fund VFIFX — — Vanguard Target Retirement 2055 Fund VFFVX — — Vanguard Target Retirement 2060 Fund VTTSX — — Vanguard Target Retirement 2065 Fund VLXVX — — Vanguard Target Retirement Income Fund VTINX — — Vanguard Institutional Target Retirement 2015 Fund — — VITVX Vanguard Institutional Target Retirement 2020 Fund — — VITWX Vanguard Institutional Target Retirement 2025 Fund — — VRIVX Vanguard Institutional Target Retirement 2030 Fund — — VTTWX Vanguard Institutional Target Retirement 2035 Fund — — VITFX Vanguard Institutional Target Retirement 2040 Fund — — VIRSX Vanguard Institutional Target Retirement 2045 Fund — — VITLX Vanguard Institutional Target Retirement 2050 Fund — — VTRLX Vanguard Institutional Target Retirement 2055 Fund — — VIVLX Vanguard Institutional Target Retirement 2060 Fund — — VILVX Vanguard Institutional Target Retirement 2065 Fund — — VSXFX Vanguard Institutional Target Retirement Income Fund — — VITRX
@msf, thanks for the correction and pointing out the difficulty of creating classes within Regular TDF fund-of-funds structure. So, may be Vanguard should have skipped the step #1 (change in the minimum required for the Institutional TDF) and should have just proceeded directly to the merger step #2 without doing anything beforehand. But that is with perfect 20-20 hindsight.
It seems that I mixed the CG and class details of Regular TDF series vs Institutional TDF series with another unrelated Regular TSM series (VTSMX / VTSAX / VITSX ...) vs Institutional TSM series (VITNX /...) where the latter series has had quite high CGs due to large outflows. But there, no merger/consolidations are planned and no lawsuits have been filed (or, I haven't heard about them). The Institutional classes within these 2 TSM series now have the same ERs, but the Regular TSM series has even lower ER classes and also the patented VG ETF class, so some artificial motivations for outflows from latter series may exist. And the parties suffering from unexpected large CGs are big institutional folks and they are supposed to be better informed and resourced.
It's Friday night, thoughts getting a little weird. Below the image is my Rube Goldberg-ish idea on what Vanguard might have done.
When the institutional investors place exchange orders from retail to institutional class shares, Vanguard redeems their retail shares in-kind (OEFs as well as ETFs can do this).
Institutional shareholders then sit with retail shares of a half dozen Vanguard funds (the underlying funds in the retail target date funds). Vanguard executes tax-free exchanges (not that it matters inside the retirement plans) of these retail shares into institutional shares of the same underlying funds.
These funds now constitute "creation units" that are used to purchase shares of the institutional target date funds
Thus, no sale of underlying funds in the retail funds; no recognized gain. In fact, reduction of unrealized gain - just like ETFs.
Vanguard might have been able to turn the mass migration into a positive rather than a costly negative.
Needless to say there are a lot of details I haven't checked; this is just some end-of-week rambling. But if Vanguard could have made something like this work, it really looks negligent for not doing it.
Comments
https://mutualfundobserver.com/discuss/discussion/59772/vanguard-settles-on-tdfs-with-ma-regulators
The reporting on this has left me rather confused. As near as I can tell, Massachusetts was focused on the marketing of the funds, not how Vanguard disrupted them. The WSJ writes: And an earlier Wealth Management.com piece talks about Mass.' concerns with "'potential tax disclosure issues' with b/d's target date funds" and that Mass. sent letters to "Vanguard, Fidelity Brokerage Services [not FMR as manager of its target date funds], ...".
All of which leads me to think that this settlement has got nothing to do with how Vanguard generated the cap gains distribution and everything to do with how the funds were sold.
Assuming that's correct, wouldn't any broker/dealer who sold these funds be a target of Mass.' ire? Admittedly most sales of Vanguard fund shares to retail investors are direct through Vanguard.
I'm troubled by Mass.' complaint (if I'm reading this correctly), that investors didn't have adequate warning. The ultimate marketing material for funds is their prospectus. By law it must precede or accompany any sale of a fund. The prospectus tax disclosures for the Vanguard target date funds is nearly identical, line for line, with the prospectus disclosure for VHCOX (Capital Opportunities), a higher risk fund. One finds the same bullet item:
• Capital gains distributions may vary considerably from year to year as a result of the Funds' normal investment activities and cash flows.
If the target date funds failed to give adequate disclosure about potential risks (viz. that a large exodus could generate ginormous tax bills), then likewise VHCOX has failed to give adequate warning. The only difference is that the VHCOX investors haven't gotten burned yet.
An additional source of confusion is that none of the reporting indicates what effect, if any, this will have on investors' suit against Vanguard - for creating the tax liability, not for failing to warn. Does the settlement preempt this suit? Does the settlement permit investors to opt out so that they can continue their suit. What is the status of the investor suit?
https://www.financialadvisoriq.com/c/3536934/449764/vanguard_sued_over_taxable_distributions_tdfs
Class Action Complaint
Thanks for your time, Derf
(for $100M+ accounts) to institutional fund shares and avoid this debacle?
OTOH, if investors waited until early April to sell shares to pay the extra taxes, they already lost quite a bit.
Either way, one has to ask where they're getting the cash from to buy back their shares. If they had the cash on hand, they might not have sold their shares to pay the extra taxes.
Another concern is that the large distributions put many investors into higher tax brackets, even for cap gains. They might have been in the 0% bracket but got pushed into the 15% bracket. And those in the 15% bracket might have been pushed into the 20% bracket. Not to mention the 3.8% Medicare surtax on investment income above a certain threshold.
Given that target date funds are designed to be an all-in-one portfolio, it would not be surprising to see even relatively small investors pushed into higher brackets.
In short, it's a nice hope that some of these investors came out better by being forced to sell shares at a market high. But given the difficulty in raising cash to rebuy later, given the higher brackets that their "windfall" pushed them into, it seems more likely that they got creamed.
The retail fund didn't have institutional shares (at least I don't think so). So Vanguard could not simply convert shares in the retail class. But Vanguard could have created a new $100M min share class in the retail fund and then converted shares. Then institutional investors wouldn't have migrated from the retail fund to the institutional clone.
I wonder why Vanguard didn't create a new $100M minimum share class and then convert shares.
This would have saved some retail investors a lot of grief!
There was a Regular TDF series (with multiple classes, including its own Institutional class), and another distinct Institutional TDF series ("Institutional" was in its name) with super high minimum and super low ER. Then 2 VG events happened, in hindsight, in a very poor way/order. First, the minimum for the Institutional TDF series was lowered that caused the stampede out of the Regular TDF series into the Institutional TDF. Second, the Institutional TDF series was merged into the Regular TDF series (so, the Regular TDF name and tickers were the survivors) and the new ER lowered below the ERs of both series forms. So, all that money that flowed out of the Regular TDF from step #1 came right back into the Regular TDF after merger step #2. In its PR releases at the times, VG mentioned only the ER savings in step #1 and then also in step #2, and didn't mention/acknowledge/admit the CG tax issues/hits by nonretirement investors until the class action suits and state regulatory actions were filed. This is called penny-wise, pound-foolish.
What VG should have done? Instead of step #1, it should have just lowered the ER of the Regular TDF institutional class to match that of Institutional TDF ahead of the merger, and then the merger step #2 wouldn't have created all this mess.
https://www.sec.gov/Archives/edgar/data/752177/000168386320000191/f2353d1.htm
That's why Vanguard would had to have created a Regular TDF institutional class.
Edit: As I think about it, creating such a share class would have been problematic. Vanguard charged no management fees or any direct fees at all for these funds. The total ER came from acquired fund expenses. That's likely why Vanguard created a clone fund with lower expenses. The institutional clone cost less because it purchased less expensive shares of the same underlying funds. I don't know how Vanguard could create a share class of the retail series with lower charges than what the underlying funds were charging.
It seems that I mixed the CG and class details of Regular TDF series vs Institutional TDF series with another unrelated Regular TSM series (VTSMX / VTSAX / VITSX ...) vs Institutional TSM series (VITNX /...) where the latter series has had quite high CGs due to large outflows. But there, no merger/consolidations are planned and no lawsuits have been filed (or, I haven't heard about them). The Institutional classes within these 2 TSM series now have the same ERs, but the Regular TSM series has even lower ER classes and also the patented VG ETF class, so some artificial motivations for outflows from latter series may exist. And the parties suffering from unexpected large CGs are big institutional folks and they are supposed to be better informed and resourced.
When the institutional investors place exchange orders from retail to institutional class shares, Vanguard redeems their retail shares in-kind (OEFs as well as ETFs can do this).
Institutional shareholders then sit with retail shares of a half dozen Vanguard funds (the underlying funds in the retail target date funds). Vanguard executes tax-free exchanges (not that it matters inside the retirement plans) of these retail shares into institutional shares of the same underlying funds.
These funds now constitute "creation units" that are used to purchase shares of the institutional target date funds
Thus, no sale of underlying funds in the retail funds; no recognized gain. In fact, reduction of unrealized gain - just like ETFs.
Vanguard might have been able to turn the mass migration into a positive rather than a costly negative.
Needless to say there are a lot of details I haven't checked; this is just some end-of-week rambling. But if Vanguard could have made something like this work, it really looks negligent for not doing it.